There is an op-ed piece in the Wall Street Journal that I believe everyone should read. It is written by Jeremy Siegel and Jeremy Schwartz and is titled “The Great American Bond Bubble.” (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html?mod=WSJ_Opinion_LEADTop&mg=reno-wsj) I believe this article is important enough and should be read even if you don’t exactly agree with the argument, which I don’t.
Siegel and Schwartz contend that the current “bubble” in the bond market is comparable to the bubble that occurred in the United States stock market in the 1990s. The reason for this bubble: “Just as investors were too enthusiastic then about the growth prospects in the economy, many investors today are far too pessimistic.” In effect, they argue, investors are too concerned about the possibility of slow economic growth and price deflation.
In order to make these “bets” investors have moved money from the stock market into the bond market. “The Investment Company Institute reports that from January 2008 through June 2010, outflows from equity funds totaled $232 billion while bond funds have seen a massive $559 billion of inflows.”
My argument is slightly different. The Federal Reserve has held its target interest rate, the Federal Funds rate, in a range from zero percent to 0.25% since December 16, 2008 to the present. The yield on the 10-year constant maturity, United States Treasury issue has ranged over this time from about 4.00% to about 2.75% where it now stands at. The 3-year constant maturity has stayed in the 2.00% to 0.80% range.
Thus, investors could (and can) borrow money at close to zero interest and invest at a substantial spread...and THIS IS A RISK FREE TRANSACTION!
This is called the “carry trade”! Duh!
What about interest rate risk, the risk that interest rates will rise?
Well, the Federal Reserve, in its infinite wisdom, has taken care of that by promising the financial markets that it will maintain its low target interest rate for “an extended time.” Well, the “extended time” has lasted for twenty months so far and given the news coming out of the Open Market Committee meeting last week, it sounds like the “extended time” will last well into 2011.
The carry trade seems like it has a pretty safe bet for “an extended period of time.”
The Fed seems to be accomplishing two things in following such a policy. First, it is helping the Federal Deposit Insurance Corporation, the FDIC, resolve the problem of dealing with a massive amount of insolvent “smaller” banks in an orderly fashion. This work-out still has a long way to go by all accounts.
Second, the Fed is helping the federal government place massive amounts of debt. Never before has so much government debt been placed in the open market. And, given projections that the federal government will have to place $15 trillion or more of its debt in the next ten years, the Fed faces a daunting task of accommodating such a huge supply of Treasury securities.
The Federal Reserve has certainly accomplished some major things in helping the FDIC and the Treasury Department and in doing so has subsidized the large banks, major corporations, and other investment funds who could partake of the “carry trade” opportunities it created. Too bad if you are a smaller organization or don’t have the wealth to partake.
The Fed subsidy is lining the vaults of the large banks, the large corporations, and the large
investment pools. They are awash in cash!
And, we have a bubble in the bond markets!
This is the third financial market bubble in the last 15 years or so: the stock market bubble in the late 1990s; the bubble in the housing market in the 2000s; and now the bond market bubble. All of these are a product of the Federal Reserve.
I don’t disagree with Siegel and Schwartz in terms of the possible consequences of the current bubble.
“Those who are now crowding into bonds and bond funds are courting disaster.”
“Furthermore, the possibility of substantial capital losses on bonds looms large.”
“One hundred times earnings was the tipping point for the tech market a decade ago. We believe that the same is now true for government bonds.” (Siegel and Schwartz contend, for example, that “The interest rate on standard noninflation-adjusted Treasury bonds due in four years has fallen to 1% or 100 times its payout.”)
However, given my argument, these consequent outcomes and the timing of them depends upon the Fed. The “extended time” will end at some point in the future and the Fed will have to let rates rise. When it does there will be a whole bunch of new problems it will have to face.
The Fed seems to be careening from one serious problem to another and appears to be “out-of-control”. (http://seekingalpha.com/article/220224-does-the-fed-even-know-what-it-s-doing-anymore) Over the past 15 years or so, the Fed has created one bubble after another, one problem after another, and now finds itself in an almost untenable position. It has pumped an excessive amount of reserves into the banking system. It is subsidizing the cash pools of large banks, large corporations, and large money interests. It has been overly accommodative to the financing of the debt of the federal government. And, now its risks bankrupting a large number of people, as Siegel and Schwartz suggest, when it ever raises its interest rate target. What next?
Showing posts with label stock market bubble. Show all posts
Showing posts with label stock market bubble. Show all posts
Wednesday, August 18, 2010
Thursday, October 29, 2009
More Talk About Credit Bubbles
Bloomberg put up a headline this morning that I found eye-catching: “Stock Market ‘Bubble’ to End, Morgan Stanley Says”, http://www.bloomberg.com/apps/news?pid=20601110&sid=a.YErMIwMYKA. Ruchir Sharma, who oversees $25 billion in emerging-market stocks at Morgan Stanley, is quoted as saying “the (global stock market) rally will end as the effects of the (government) stimulus begins to fade and the credit bubble caused by easy money disappears.”
We are still learning about asset bubbles and credit bubbles so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.
“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma states. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”
“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”
According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.
Rather than the funds going directly into the spending flow, increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.
How could this situation have evolved having just gone through three recent experiences of asset or credit bubbles, the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?
In this respect, another person, Arthur Smithers, with a “deep understanding of economics and a lifetime’s experience of financial markets” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times: http://www.ft.com/cms/s/0/38164e12-c330-11de-8eca-00144feab49a.html.) has also questioned current values in stock markets.
Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co, http://www.smithers.co.uk/, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance”, http://www.irrationalexuberance.com/index.htm.)
Both measures relating to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.
According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But, it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.
A reason why the value of the stock market may deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha: http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers.)
Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.
Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”
This is exactly the problem that I presented in my posts of October 26, http://seekingalpha.com/article/168852-the-state-of-the-economy-the-good-news-and-the-not-so-good-news, and October 27, http://seekingalpha.com/article/169130-is-it-time-for-more-economic-stimulus. The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.
Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But, these problems are for another time, and the politicians don’t have to focus on yet.
We are still learning about asset bubbles and credit bubbles so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.
“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma states. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”
“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”
According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.
Rather than the funds going directly into the spending flow, increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.
How could this situation have evolved having just gone through three recent experiences of asset or credit bubbles, the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?
In this respect, another person, Arthur Smithers, with a “deep understanding of economics and a lifetime’s experience of financial markets” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times: http://www.ft.com/cms/s/0/38164e12-c330-11de-8eca-00144feab49a.html.) has also questioned current values in stock markets.
Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co, http://www.smithers.co.uk/, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance”, http://www.irrationalexuberance.com/index.htm.)
Both measures relating to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.
According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But, it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.
A reason why the value of the stock market may deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha: http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers.)
Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.
Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”
This is exactly the problem that I presented in my posts of October 26, http://seekingalpha.com/article/168852-the-state-of-the-economy-the-good-news-and-the-not-so-good-news, and October 27, http://seekingalpha.com/article/169130-is-it-time-for-more-economic-stimulus. The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.
Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But, these problems are for another time, and the politicians don’t have to focus on yet.
Monday, October 19, 2009
The Stock Market: A Bubble or Not?
Questions are now being asked about the nature of the rise in the stock market. These questions have to do with the reality of the rise, how high the market will go, and when will the economy produce results that are consistent with the optimism captured in the stock market rise.
There is another way to look at the rise in the stock market since March 2009: the rise could be just another asset bubble.
Asset bubbles are a form of inflation. As we have learned over the past fifty years, excessive monetary or credit ease can come out in one of three ways. First, there can be outright inflation. In this case, popular price indices, like the Consumer Price Index, can rise by inflated amounts. Second, prices of assets in one or more sectors of the economy can rise at a pace that exceeds the rate justified by the underlying fundamentals of the sector. Third, when the economy is facing supply side adjustments that constrain the healthy growth of the economy, excessive monetary or credit ease can force economic growth in areas that have declined in productivity. That is, the excessive monetary growth can force resources back into declining industries rather than allow them to adjust into the more productive areas of the economy that are in the process of expanding. In these cases nominal growth of the economy is higher than it would be otherwise and inflation is muted by the re-kindling of industries that needs to change or modernize. This results in a form of “stagflation” where we get the worst of both slow growth and masked inflation.
There is little doubt that the monetary authorities have pumped plenty of liquidity into the banking system. The year-over-year increase in the monetary base (currency in circulation plus bank reserves) has been increasing at a rate of around 100% for the past year. As yet, little of this liquidity has found its way into bank lending.
Still, the two basic measures of the money stock have shown year-over-year rates of increase that, historically, can be considered to be substantial. The M1 measure of the money stock has been rising for months in the range of 15% year-over-year, while the M2 measure of the money stock has been rising in the 8% range over the same span of months. Some of this growth can be attributed to a re-arranging of asset portfolios into more liquid assets. Still, all of this money is not sitting idle even though interest rate levels are historically low.
How might this expansion of the monetary variables be used? In the past, rates of growth like this would be considered to be inflationary. Yet, there is no evidence that spending on final goods has increased appreciably and, hence, the rate of increase of consumer prices has remained just above zero, year-over-year. There has been some growth of the economy and some of this growth can be attributed to areas where resources had been leaving (autos) to move to more productive operations. The government stimulus spending has produced a spike in output here and there but does not seem to have produced any sustained increases in economic growth. The possibility of stagflation seems to lie in the future. Therefore, it seems as if two of the three outlets for monetary ease can be excluded from the present analysis.
That leaves us looking for the existence of an asset bubble. Certainly the movement in the stock market since March is a good place to look for a possible asset bubble.
We certainly have some experience in stock market bubbles having just gone through the stock market bubble of the 1990s. Could we be having a repeat performance?
In terms of assessing this possibility I am going to turn to two measures of stock market valuation that were discussed in a book I recently reviewed. The book is titled “Wall Street Revalued” and was written by Arthur Smithers. The review can be found at http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers. The two measures are Tobin’s Q ratio and the Cyclically Adjusted Price/Earnings (CAPE) ratio developed by Robert Shiller. In mid-September, these ratios were already showing that the U. S. stock markets were 35% to 40% overvalued, and that was before the run-up that took the Dow above 10,000. (For a report on these numbers see http://www.ft.com/cms/s/0/b82d2b96-bc02-11de-9426-00144feab49a.html.)
Is the rise in U. S. stock markets a bubble?
Bubbles, of course, are easier to define after-the-fact than when they are occurring. But, the “Q” ratio and the CAPE have done a pretty good job historically of indentifying times when the stock market is overvalued.
If the stock market is overvalued right now because the Federal Reserve has created another asset bubble--it’s third in about 15 years—then the economic and financial situation in the United States is quite tenuous. The economy sucks, the banking system is still faced with major credit problems, and the dollar has fallen close to 15% since January 20, 2009. What kind of a policy can the government throw at this dilemma?
Any tightening to brake the expansion of the bubble and/or combat the decline in the value of the dollar threatens the solvency of the banking system and the fragility of the economic recovery. But, as we have seen over the past 15 years, bubbles eventually collapse on their own. Are there any “good” ways out of this situation?
This is not a pretty sight, but it is one we must take into consideration. As we continue to learn, though, once we lose our discipline, all the good choices in policy seem to disappear!
There is another way to look at the rise in the stock market since March 2009: the rise could be just another asset bubble.
Asset bubbles are a form of inflation. As we have learned over the past fifty years, excessive monetary or credit ease can come out in one of three ways. First, there can be outright inflation. In this case, popular price indices, like the Consumer Price Index, can rise by inflated amounts. Second, prices of assets in one or more sectors of the economy can rise at a pace that exceeds the rate justified by the underlying fundamentals of the sector. Third, when the economy is facing supply side adjustments that constrain the healthy growth of the economy, excessive monetary or credit ease can force economic growth in areas that have declined in productivity. That is, the excessive monetary growth can force resources back into declining industries rather than allow them to adjust into the more productive areas of the economy that are in the process of expanding. In these cases nominal growth of the economy is higher than it would be otherwise and inflation is muted by the re-kindling of industries that needs to change or modernize. This results in a form of “stagflation” where we get the worst of both slow growth and masked inflation.
There is little doubt that the monetary authorities have pumped plenty of liquidity into the banking system. The year-over-year increase in the monetary base (currency in circulation plus bank reserves) has been increasing at a rate of around 100% for the past year. As yet, little of this liquidity has found its way into bank lending.
Still, the two basic measures of the money stock have shown year-over-year rates of increase that, historically, can be considered to be substantial. The M1 measure of the money stock has been rising for months in the range of 15% year-over-year, while the M2 measure of the money stock has been rising in the 8% range over the same span of months. Some of this growth can be attributed to a re-arranging of asset portfolios into more liquid assets. Still, all of this money is not sitting idle even though interest rate levels are historically low.
How might this expansion of the monetary variables be used? In the past, rates of growth like this would be considered to be inflationary. Yet, there is no evidence that spending on final goods has increased appreciably and, hence, the rate of increase of consumer prices has remained just above zero, year-over-year. There has been some growth of the economy and some of this growth can be attributed to areas where resources had been leaving (autos) to move to more productive operations. The government stimulus spending has produced a spike in output here and there but does not seem to have produced any sustained increases in economic growth. The possibility of stagflation seems to lie in the future. Therefore, it seems as if two of the three outlets for monetary ease can be excluded from the present analysis.
That leaves us looking for the existence of an asset bubble. Certainly the movement in the stock market since March is a good place to look for a possible asset bubble.
We certainly have some experience in stock market bubbles having just gone through the stock market bubble of the 1990s. Could we be having a repeat performance?
In terms of assessing this possibility I am going to turn to two measures of stock market valuation that were discussed in a book I recently reviewed. The book is titled “Wall Street Revalued” and was written by Arthur Smithers. The review can be found at http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers. The two measures are Tobin’s Q ratio and the Cyclically Adjusted Price/Earnings (CAPE) ratio developed by Robert Shiller. In mid-September, these ratios were already showing that the U. S. stock markets were 35% to 40% overvalued, and that was before the run-up that took the Dow above 10,000. (For a report on these numbers see http://www.ft.com/cms/s/0/b82d2b96-bc02-11de-9426-00144feab49a.html.)
Is the rise in U. S. stock markets a bubble?
Bubbles, of course, are easier to define after-the-fact than when they are occurring. But, the “Q” ratio and the CAPE have done a pretty good job historically of indentifying times when the stock market is overvalued.
If the stock market is overvalued right now because the Federal Reserve has created another asset bubble--it’s third in about 15 years—then the economic and financial situation in the United States is quite tenuous. The economy sucks, the banking system is still faced with major credit problems, and the dollar has fallen close to 15% since January 20, 2009. What kind of a policy can the government throw at this dilemma?
Any tightening to brake the expansion of the bubble and/or combat the decline in the value of the dollar threatens the solvency of the banking system and the fragility of the economic recovery. But, as we have seen over the past 15 years, bubbles eventually collapse on their own. Are there any “good” ways out of this situation?
This is not a pretty sight, but it is one we must take into consideration. As we continue to learn, though, once we lose our discipline, all the good choices in policy seem to disappear!
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